Negative interest rates may or may not be a thing of the past (many thought that the ECB had learned its lesson, and then Vitor Constancio wrote a blog post showing that the ECB hasn’t learned a damn thing), but the confusion about their significance remains. Here is Deutsche Bank’s Dominic Konstam explaining how, among many other things including why Europe will need to “tax” cash before this final Keynesian experiment is finally over, negative rates are merely the logical failure of globalization.

Misconceptions about negative interest rates

Understanding how negative interest rates may or may not help economic growth is much more complex than most central bankers and investors probably appreciate. Ultimately the confusion resides around differences in view on the theory of money. In a classical world, money supply multiplied by a constant velocity of circulation equates to nominal growth. In a Keynesian world, velocity is not necessarily constant – specifically for Keynes, there is a money demand function (liquidity preference) and therefore a theory of interest that allows for a liquidity trap whereby increasing money supply does not lead to higher nominal growth as the increase in money is hoarded. The interest rate (or inverse of the price of bonds) becomes sticky because at low rates, for infinitesimal expectations of any further rise in bond prices and a further fall in interest rates, demand for money tends to infinity. In Gesell’s world money supply itself becomes inversely correlated with velocity of circulation due to money characteristics being superior to goods (or commodities). There are costs to storage that money does not have and so interest on money capital sets a bar to interest on real capital that produces goods. This is similar to Keynes’ concept of the marginal efficiency of capital schedule being separate from the interest rate. For Gesell the product of money and velocity is effective demand (nominal growth) but because of money capital’s superiority to real capital, if money supply expands it comes at the expense of velocity. The new money supply is hoarded because as interest rates fall, expected returns on capital also fall through oversupply – for economic agents goods remain unattractive to money. The demand for money thus rises as velocity slows. This is simply a deflation spiral, consumers delaying purchases of goods, hoarding money, expecting further falls in goods prices before they are willing to part with their money.

For an economy that suffers from deficient demand, lowering interest rates doesn’t work if it simply lowers expected returns on real capital through oversupply. The shale boom in the US is blamed on cheap money. As Gesell also argued, where Marx was wrong but Proudhon was right, is that to destroy capitalism you don’t need workers to strike and close the capitalists’ factories; instead the workers should organize and build another factory next to the capitalists. The means of the production are nothing more than capitalized labor. Oversupply destroys capitalism in a natural way. In this way the demise of positive interest rates may be nothing more than the global economy reacting to a chronic oversupply of goods through the impact of globalization including the opening up of formerly closed economies as well as ongoing technological progress.

Of course raising rates isn’t a solution. If effective demand is deficient due to money hoarding of new money supply and a decline in velocity when goods supply is expanding, in a rising rate environment, demand is deficient with money supply itself falling regardless of any change in velocity. Interest on real capital may rise, even with goods prices stable eventually recovering but at the cost of huge unemployment and social distress. The difference can be thought of as the aggregate demand curve shifting inwards relative to supply and supply still exceeding demand when monetary conditions are too tight versus a falling interest environment whereby the aggregate supply curve moves out relative to demand such that the curves don’t intersect at prices above zero – the latter reflecting an implied rising real money interest rate.

In a Keynesian world of deficient demand, the burden is on fiscal policy to restore demand. Monetary policy simply won’t work if there is a liquidity trap and demand for cash is infinite. Interest rates cannot be reduced any further to stimulate demand. (In Gesell’s terminology the product of velocity and money supply i.e. effective demand keeps falling). In Gesell’s world money itself needs to be taxed to prevent hoarding and to equalize the worth of money to goods. If cash is taxed (and he suggested at the annual tax rate might be 5.2 percent, according to Keynes) then velocity is stabilized, demand for money falls and goods demand recovers. The tendency to oversupply however in an economy unfettered by “privilege” effectively implies that interest rates in equilibrium may converge to zero. Taxing of money specifically is to deal with an ex ante effective demand deficiency.

Europe’s long time obsession with negative rates, to quote our present day Fischer, is fair but misleading in the context of how negative interest rates are being applied. The combination of penalty rates on banks’ excess reserves and QE is designed at one level to expand private sector credit. This if anything will promote supply of goods. If supply creates its own demand and/or if Keynesian investment accelerator models are valid, then they may well be successful in restoring a Keynesian deficient demand problem.

This is essentially the same as saying there is no liquidity trap. (If we think of the inverse bond price on the vertical axis as being a private sector asset price, then a large price rise can be achieved for a relatively small amount of money expansion). But it presupposes that there is deficient loan demand due to high money capital interest rates rather than due to too low real capital expected returns. The risk is that QE itself is simply new money being hoarded on the demand side so that money velocity falls and effective demand remains weak. Falling interest rates may well promote new loan demand and increase supply but only in a deflationary spiral of further falls in expected capital returns and the perceived need for still lower money interest rates. If Gesell is correct, it is essential to tax money itself which means not just retail deposits but cash in circulation. Then velocity would stabilize with effective demand as households would be willing to own goods rather than money. It is conceivable that the Europeans are heading in this direction and maybe it will be worse before it gets better. Or maybe there is still time for the Keynesian mechanism to prove that we are not in a liquidity trap.

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Here is our far simpler explanation of what Konstam just said, and why DB would much prefer more QE over NIRP: QE takes away the liquidity preference choice out of the hands of the consumers, and puts it into the hands of central bankers, who through asset purchases push up asset prices even if it does so by explicitly devaluing the currency of price measurement; it also means that the failure of NIRP is – by definition – a failure of central banking, and if and when the central bank backstop of any (make that all) asset class – i.e., Q.E., is pulled away, that asset (make that all) will crash. The only asset that does not have a central bank backstop (in fact, central banks are actively pushing it lower)? Gold.